Are 401k Accounts a Scam?

I’m no financial expert, but I try to follow the basic principles of investing and retirement savings in order to hopefully not be dirt poor in old age. One of these principles has been to consistently max out my 401(k) each year, which I’ve done faithfully now for many years, ever since I finally had access to a retirement account at work. As soon as as started making too much money for a Roth IRA, I socked away $18k a year in my 401k… and now, between all my pre- and post-tax retirement accounts, I have about $235k locked away, compounding over time.

However, after reading more propaganda on 401k investing, I started to suspect something fishy is up. Most of the anti 401k content focuses on issues with high fees — which, indeed, are a big problem with 401ks. But, really, the most suspicious piece of messaging out there on the benefits of the 401k is that you don’t have to pay taxes now so you get the “benefit” of paying them later.

Hmm.

Basically, this assumes my tax bracket today is higher than it will be in retirement. Besides not having any idea what the tax brackets will look like in 35 years when the government very well may have run out of money, the core concept of making less income in retirement than as a younger person seems backwards. As a couple we may make $250k now, but in retirement, if we’ve done well enough and saved substantially, will we not want to take out this amount or more per year? Won’t our tax bracket be higher in retirement than it is now?

There are other benefits to tax-sheltered retirement accounts often cited in pro 401k articles, namely being able to trade stocks and reinvest dividends without paying any taxes over the years. But capital gains tax rates aren’t that bad compared to income tax rates and paying taxes now vs later may actually compute to more money in the long run, never mind the whole having the money liquid should you need it versus being penalized by 10% above and beyond income tax to take the money out early. Perhaps the 401k is actually a really bad investment strategy, designed to try to convince the masses to save for retirement when companies decided to no longer be responsible for helping their employees not spend their last years on earth begging on the streets.

One of these days, I’m going to figure out how to build a calculator that shows the variations of retirement investment options to see what makes the most sense. In the mean time, I’m going to look at one model to see in very simple math which investment vehicle makes more sense for a married couple making $300k per year. I’m looking at federal taxes only for the sake of simplicity, but really one should also factor in state taxes.

Investment Amount in Taxable Account

Let’s assume the married couple are both 30 years old and jointly make $300k per year. This puts them into the 33% tax bracket. In 2017, they jointly will be responsible for $74.2k in taxes. This, again, is a very simplistic view because I’m purposefully ignoring further deductions (married couples phase out of the standard deduction at $313k this year, btw) and considering the married couple renters to start so there are no mortgage deductions or anything else.

Without putting any money into a 401k, the married couple now has $225.8k to spend over the course of the year. Let’s say they spend $6k per month on living expenses, or $72k, leaving them with about $153.8k to invest after taxes.

The math gets a bit tricky here, so I’ve relied on an online dividend compound interest calculator to attempt to estimate the amount the couple would have in 35 years.

Assumptions:

  • Starting Principal: $153.8k
  • Annual Addition: $153.8k
  • Dividend Tax Rate: 15%
  • Avg Annual Dividend Yield: 2.5%
  • Expected Increase (per year): 5%
  • Years Invested: 35 years

This says that with these numbers, after 35 years, the account value will be $23,690,895 (yes, that’s $23 million dollars after 35 years with just a 5% increase and 2.5% dividend yield, which is what the S&P has returned on average.

Ok, so you get to 65 and you have $23M between the two of you to spend, continue to invest, give away to charity, or roll around in. Although you will continue to pay tax on the dividends and eventually what you take out will be taxed at capital gains rates (which could certainly go up), no one will force you to take distributions from the account at any age (401ks have required minimum distributions, which means you’re paying income tax each year of retirement even if you’ve saved up enough to live on elsewhere.)

While there are other taxes that will be taken out of this amount (i.e., state tax), so annual savings will be decreased, we’re going to keep going down this simple understand the point path to say you have $23.6M together after 35 years. Your principle can be taken out tax free ($5.38M) and the remaining $18.22M would be taxed at capital gains tax rates. Let’s say that’s 20% in retirement, you’ll end up with $14.5M after paying capital gains taxes, or a total of $19.95M after tax.

What if You Put This $ into a 401k?

Ok, so making $300k as a married couple puts you in a rather high tax bracket. If you were single still, any income you made over $191.6k would be taxed at 33%, while as a married couple anything made jointly over $233k is taxed at 33%. Yup, that means as two single people you could together make $380k and not yet have to pay 5% more tax on every dime over that amount, whereas if you’re married, you’re paying 5% more federal tax on up to $150k of income (yeay marriage tax penalty.) That’s not the point of this article. Anyway, let’s say you want to decrease your tax burden today, so you both put the max amount into your 401k accounts ($18k.)

By maxing out your 401k today, your taxable income is reduced to $264,000 as a married couple, meaning you’re only paying $30.6k worth in the 33% tax bracket ($10.1k) plus $52.2k, so you’re paying $62.3k in taxes versus $74.2k if you didn’t put the money into the 401k. So you have a bit more to invest up front, but most of it is locked away in the 401k account.

The married couple has $201.7k to live on and invest in taxable accounts remaining after maxing out their 401ks, plus $36k in the 401k accounts. This is where the math gets more complicated and I need help from someone better at numbers…

P1 – Taxable Account

  • Starting Principal: $129k
  • Annual Addition: $129k
  • Dividend Tax Rate: 15%
  • Avg Annual Dividend Yield: 2.5%
  • Expected Increase (per year): 5%
  • Years Invested: 35 years

$19,870,777 …
$4.5M principle…
$15.3M gains @ 20% =
$12,284,621 left + principle =
$16,784,621M, PLUS…

401k Money…

So, the question is, does the 401k savings over the 35 years and taxes paid on this savings upon distribution end up providing more or less than $3.17M?

Math time.

So, you have 35 years of money going into the tax shelter, and each year the dividend yield is 2.5% and you’re increasing the value of that account by 5%. You aren’t paying any taxes on it over those 35 years…

Using the same online dividend tax calculator, I’ve plugged in the following variables:

  • Starting Principle: $36k
  • Annual Addition: $36k
  • Dividend Tax Rate: 0%
  • Avg Annual Div Yield: 2.5%
  • Expected Increase: 5% per year
  • Years Invested: 35

This offers $6,045,231 after 35 years. However, this money will be taxed at income tax rates, not capital tax gains rates. While we might not even need to take money out of this account since we’ve saved so much in our taxable accounts already, we’re forced to take a distribution (yup, the government makes you take money out of your 401k so they can collect tax).

Figuring out what a retired minimum distribution will look like is tough, but Vanguard’s RMD calculator is a good place to start. It gets kind of morbid, because you have to calculate your life expectancy factor to determine how much you have to take out. For instance, if you’re 70 years old, the government expects you to live for 27.4 more years. If you’re 90, though, they assume you’ll last another 11.4 on average. Well, if you have $6M saved up for retirement in your 401k accounts (which is a good problem to have), or $3M per partner, you’ll have to divide that $3M up by how long the government expects you to live and start taking money out when you turn 70 and 1/2. So with $6M together in 401ks, you’ll have to take $218.9k out per year, even if you don’t need it, once you turn 70 1/2. (*if I’m misunderstanding this, someone please explain.)

What’s bad about this is that you have to pay income tax on $218.9k. Maybe this isn’t a huge problem if you have saved up anywhere near the numbers I’m talking about here, but I’m using this as one example just to explain the principle. We can plug lower incomes in to see that the same issues arise, and could cause more hardship. In any case, I’m just trying to sort out if the tax savings from 401ks actually is a savings at all, or just a slight of hand by the government to make you pay them more while thinking you’re paying them less!

Ok, so at the age of 70 1/2 you are paying taxes on 218.9k per year as a married couple, or, in current tax brackets, that money would cost $48.1k in taxes per year, leaving $170k left each year over those 27.4 years of average life expectancy. To make the math more complicated, the money you haven’t taken out of your account could theoretically be continuing to earn 5% per year, but let’s assume you’ve put most of your money into safer investments and/or cash so you’re not increasing value over those 27.4 years. Again, this is a simplistic way of looking at things, as you could be still aggressively investing part of your portfolio remaining in your 401k, or you could be taking out more money from your 401k because you need it (if you haven’t saved as much in taxable accounts as well or if your money is tied up in, say, a mortgage and other illiquid investments.) So you end up after 27.4 years with $4.67M, which does end up giving you $21.46M, more than the $19.95M we ended up with in the other example.

But, and the big but is, will tax brackets be higher in 35 years when we retire? Probably. What if the government is broke and needs your money, and the tax rate is a flat 40% on retirement accounts? You end up with $3.59M after 27 years… basically breaking even with the 401k investment.

So, in this case, the 401k investment doesn’t look horrible. But you also have to weigh…

  • 10% penalty for removing funds before retirement age
  • 401k fund fees, which are often higher than taxable fund offerings (which can significantly eat into the growth of the 401k account)
  • Increased payments for things like mortgages since you have less to put down up front since you’re putting money in your retirement accounts
  • When heirs inherit a 401k, they have to pay income tax on this money.  With taxable accounts, inherited funds, the tax basis is stepped up to the tax basis on the date of death. This is actually a pretty huge deal, if you have managed to save $20M over your life and want to pass that on to your heirs. For the super wealthy and smart savers, this makes a huge difference. Basically, when a child inherits a mutual fund from their parents, the basis (anything above the basis is taxable at capital gains rates) is stepped up to the value on the date of the person’s death. Those funds can be sold immediately, with very little tax liability for the inheritor.  *The estate tax would be levied before this on estates worth over $10.9M per married couple or $5.45M per person, which would be an issue in the above example of the couple who has saved a lot and hasn’t spent any of the money. No one needs to hand off more than $10.9M to kids, so if you’re that rich in retirement give away most of your money to a charity and you won’t have to worry about your kids dealing with the estate tax.

Phew, long post, and I think I confused myself more than I helped understand this topic. There are so many tax loopholes and caveats and unknowns that it’s hard to get a grasp on the pros and cons of 401ks. I think what this post did showcase is that even without adding the additional fees of 401ks, over time, investing in a 401k or keeping money in a taxable account and paying taxes up front ends up equaling the same amount in the end.

One More (Realistic) Example

  • Married Couple Income: $100k
  • After Tax Federal: $35.45k
  • Annual Expenses: $48k
  • Remaining after Tax & Expenses: $16.5k

No 401k…

  • Value: $2.46M (after 35 years)
  • Basis: $577.5k
  • Taxable Value: $2.02M
  • @20% = $1.6M value
  • Total Account Value = $2.2M

With 401k (maxed)

  • Married Couple Income: $100k
  • Maxed 401k: $36k
  • Taxable Income: $64k
  • Federal Taxes: $8667
  • Annual Expenses: $48k
  • Remaining = $7333

$7333 Invested 35 years…

Taxable Account: $1.13M +

  • Starting Principle: $36k
  • Annual Addition: $36k
  • Dividend Tax Rate: 20%
  • Avg Annual Div Yield: 2.5%
  • Expected Increase: 5% per year
  • Years Invested: 35

This offers $6,045,231 after 35 years. Same as our earlier couple making a lot more money. Minimum distributions will be the same — leaving $170k per year for 27 years, or $4.5M, plus $1.13M, getting us to $5.7M, much more than the $2.2M with no 401k. If my math is right. Big if. And with no 401k fees included which obviously would eat into the gains.

If you’re good at tax math, is anything I shared here totally off? Am I thinking about this wrong? Do you think 401ks are a rip off or a good deal?

 

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7 comments

  1. Mr. A says:

    I don’t think 401k are a scam, but it is B.S. that you get stuck with such high fees that you wouldn’t have on the open market.

    Taking the 401k match is always worth it since it’s going to be better than the 10% penalty to withdrawal early.

    Every employer’s 401k is different but for us lifers my options are not good. I also don’t like that I can’t manipulate the account much, use options, or select individual stocks.

    I think as you pointed out, the benefit isn’t that worth it. I also want the money earlier and the flexibility to use it. I may not even live to 70.

  2. Labangel says:

    Another way to think of it is if you didn’t put $18K/yr into a 401K, would you have the discipline to put that money into a brokerage account or would you want to spend it to live better, send your child to private school or tutoring, etc. This may not be a large problem for the high earning couple in your first example, but may be one for the realistic couple making $100K/yr.
    Also consider that 401K, IRA, Roth IRA, and other retirement account balances don’t count when calculating the Expected Family Contribution when a child goes to college. This may cause the brokerage only couple to spend more on their children’s tuition than the brokerage + 401K couple.
    Finally, retirement accounts are protected in bankruptcy cases for slightly over $1M for each spouse. And of course most employers give some 401K match; the match money itself may cancel out high fees. <3,
    Labangel

    1. Joy ( User Karma: 0 ) says:

      Very true. The challenge is that the 401k in terms of “value” is worth much more for someone making a lot today, then it is someone making less today, yet it is designed to help people who are making less today save for retirement. Ie, for the couple making $100k total, their taxes today won’t be that high, so they won’t save all that much putting money in a tax deferred account where their taxes are likely to be more in retirement (if they are saving $18k a year.) For higher income earners, the 401k has major issues. For super wealthy income earners, they don’t need it, so it’s really people in the upper middle class making about $250k-$350k as a couple who are in the middle and don’t have a best choice investment option. In all my working career of 12 years I’ve never had access to a 401k match — it’s always good advice to put away enough money to get the match. I’m focusing on whether or not it makes sense to invest in 401ks without the match (or beyond the match.) Regarding scholarships, yes, you are right that they aren’t counted for when a child goes to college vs taxable accounts. This could save a family substantially, but not if they are earning $250k-$350k a year, since they’re phased out of those credits anyway. I believe real estate also doesn’t count so I’m looking into if purchasing a home is actually a better long-term investment than a 401k, which I thought wasn’t true to begin with but I need to work out the numbers. The note on retirement accounts being protected in bankruptcy is important and something I didn’t know, so there’s value there for sure, but not many people will file for bankruptcy if they are smart about money.

  3. Norm says:

    I’ve tried to do this analysis a bunch of times because my wife’s 401(k) has terrible fees (1.5% and up) which I think is the main reason you wouldn’t want to invest in a 401(k). My analysis is not as in depth as yours, but basically I do come out ahead with the 401(k) despite the fees. I do have a different set of assumptions than you do (being in the 15% tax bracket in retirement). But like you say, since we can’t predict what tax rates will be in the future, it’s pretty much impossible to know for sure.

    One thing is for sure, and that’s if you’re currently in a 15% bracket, I found a high fee 401(k) to be the worst option for savings. It’s better just to take the tax now rather than be hit with the high fee and possibly a higher tax rate in the future.

    1. Joy ( User Karma: 0 ) says:

      Everything I’ve read about 401ks being scams are about the fees (which I purposely don’t mention here much — I leave jobs every 1-4 years so I can move 401k to Vanguard IRA without fees dipping into growth too much — if you’re a lifer than yes fees alone are reason to not invest in a 401k.)

      Curious how you plan to be in 15% tax bracket in retirement? Based on my savings rates it’s possible that I will be forced into a higher tax bracket in retirement based on my minimum required distribution from my 401k alone. Right now I have $250k in my 401k give or take. Over 38 years, even if I never put another dollar into that account, with 5% YoY interest, that returns $1.6M. It could possibly perform better than that. All good problems to have, but this means that at age 70 I’ll be forced to take out 1.6M/27 every year for 27 years, or $59k per year. That’s not so bad tax wise, but if the 401k performs better than 5% and, say, sees 7% YoY for 38 years, and delivers $3.2M – this means I’d have to take out $118k a year, and this is just my account not counting anything my husband has saved up in tax-deferred accounts or social security. We’d quickly move into higher tax brackets with the forced distributions.

      Also, if we end up doing that well and we have children and want to pass our investment accounts on to our children, if they’re in taxable accounts our children would get a step up in basis on investments, whereas if they’re in 401k they have to pay income tax on the funds, which may hit at their high earning years and mess up their own taxes, versus having the flexibility of taxable accounts (as long as you haven’t made enough to trigger the estate tax, it’s much better to pass on Roths then taxable accounts then tax deferred accounts to heirs.)

      Just some food for thought.

      Yes, if you’re in a 15% tax bracket a high fee 401k is a horrible idea.

      1. Norm says:

        Might come down to location-based cost of living again. The 15% tax bracket tops out at $76,000 of taxable income. Add the standard deduction of $12,600 for married couples, plus two exemptions for $8,000, and you come out to $96,600 you can earn/withdraw from 401(k) before you exceed the 15% tax bracket. That’s a hell of a lot of money.

        We spend about $36,000 a year (not including debt). If we’re just withdrawing enough to live on, or even withdrawing $60,000 more than that, we’re still in the 15% bracket. Not to mention we could withdraw from our Roth IRAs which wouldn’t be taxed at all.

        1. Joy ( User Karma: 0 ) says:

          I’m mostly focused on the minimum required distributions for the 401k. Let’s say you invest $36k per year as a couple for 30 years from age 40 to 70. At age 70, you’ll have $2.5M at a 5% YoY rate of return. You’ll be forced by the government to take out $92.5k per year at 70 for the rest of your life until all your money is out of the account and taxed. If you have an 8% rate of return, you have $4.4M, being forced to take out $162k per year. So even if you don’t need the money, you’ll be forced to take it out annually, bumping up the tax you own on it. At some point you’re better off with taxable funds.

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